Stefan Karlsson's blog

Hard-Hitting Economics Commentary

Saturday, November 29, 2008

Week In Review

As you have noticed, I have blogged less frequently recently than before. That is because I am trying to finish a report on competition & globalization for the European Enterprise Institute. Sometime early or in the middle of next week, I hope to have it finished. Until then blogging will continue to be slow, but after that it will resume at its normal pace.

-Amity Shlaes argues in a good way against the economic agenda of Paul Krugman and Barack Obama, as well as Krugman's interpretation of the 1930s, although the essay also contains a misleading assertion about the evils of deflation.

-Despite the weak economy in Germany, German politicians and central bankers remain less Keynesian than their colleagues in the U.S. and U.K. Germany faces significant problems mainly due to the unfavorable demograhic situation created by a too low birth rate, but by resisting Keynesian solutions they will avoid creating even more problems.

Wednesday, November 26, 2008

Why Bans On Short-Selling Reduces Market Efficiency

Pehr has once again posted a question in my Q&A section of such great general interest that it deserves a separate post. His question was as follows:

"Today at our finance lecture one student asked the teacher the following question:

"Is there any negative effects for the economy by a banning short selling?"

And the teacher answered by saying that he didn't know or couldn't think of any negative effects by doing this.

My instinct though says that a banning of short-selling is NOT good for the economy but I cannot explain why. I don't have any arguments except that it interfers with the free market.

Do you have a better answer on this question?"

Yes, I do. Banning short-selling delays price adjustment to the correct value. The efficient market hypothesis is based on the assumption (as well as many other assumptions) that short-selling is possible. While I don't believe in the efficient market hypothesis for other reasons (that is, many of those other assumptions are wrong), it is correct in noting that the ability to sell short helps move markets closer to that ideal.

If a certain stock (or other asset) is overvalued, yet the people who realize this have already gotten out of the stock, then the way for them to correct this overvaluation is to sell the stock short. That way, these informed investors can bring the price closer to its fair value. But if short-selling is banned, this kind of adjustment can't take place.

Another aspect of this is that people who for some reason believe a certain stock is too cheap can use their money or even borrowed money to buy stocks they think are too cheap. Yet people who come to the conclusion that a certain stock is overvalued can't do anything about it unless they already owned the stock in the absence of short-selling. And even those that already owned the stock are limited to their stocks, while people bullish about the stock could possibly borrow to buy more of it. This creates an asymmetric situation where people bullish about a stock will have much greater influence than those that are bearish about it, which increases the risk that some stocks will be over-valued.

This would be similar to say an election where both Republicans and Democrats had the possibility of voting for the Republican candidate , but only those who had previously voted for the Republican candidate could vote for the Democrat, while previous Democratic voters who wanted to support the Democratic candidate could only have the option of abstaining from voting (abstaining from buying, so to speak) for the Republican. It should be obvious just how great bias for the Republican candidate this would create. Similarly, bans on short-selling creates a significant bias for bulls that distort stock prices and makes markets less efficient.

Tuesday, November 25, 2008

Steve Hanke & Daniel Gross On The Great Depression

With many now fearing that we're heading towards a second Great Depression, there is increased interest in the history of the first Great Depression, the one in the 1930s. Those of you interested in the correct interpretation I recommend Murray Rothbard's "America's Great Depression" (available online here, can be bought in traditional paper form here (as well as a few other online book stores)). Although it is not perfect, it is certainly far superior to all other historical accounts of that period, and the inflationary boom that preceded it, while also describing the Austrian business cycle theory in a very good way.

The main point of this point is however not to again recommend that book, but rather to discuss to recent articles about the (first) Great Depression. The first is from Cato Institute fellow Steve Hanke, who unlike many others at Cato is fairly Fed critical and hard money oriented.

His article is mostly informative and interesting, although he starts of with a really grave error, namely measuring the depth of the Depression in terms of national income in nominal terms instead of real terms. Given the massive price deflation of the time, that greatly exaggerates just how bad the downturn was. Also, his statistics in general is completely inconsistent with the numbers you find at the statistical authority that publishes these statistics, the Bureau of Economic Analysis (BEA). He claims that nominal national income fell from $84.7 billion in 1929 to $39.4 billion in 1933, whereas the BEA says that it fell from $94.2 billion to $48.9 billion (Note that I don't think that Hanke deliberately tried to mislead. Most likely he simply relied on older data series that have now been revised)..

While his specific numbers are wrong, the general trends he describe is still more or less right. He describes how the Depression shifted national income from corporate profits to net interest, which is confirmed in the BEA numbers, although the shift was somewhat less dramatic than Hanke claimed. Another relative beneficiary by the way was labor income, which in the BEA numbers rose from 54.3% of national income to 60.5%.

Hanke explains the disappearance of profits with price deflation, and a theory of profits that they are created by buying something now and selling it later, which is more difficult during price deflation. There is a limited degree of truth in that, but it also misses the distinction between price deflation caused by higher productivity and price deflation caused by monetary deflation. If productivity is rising then it can in fact be profitable to buy now input and sell finished goods later, as is illustrated by the profits made in the technology sector despite falling prices there. What caused the decline in profits during the Depression was the shift from significant monetary inflation during the 1920s to significant monetary deflation in 1930-32.

Moreover, the main cause of the collapse in profits wasn't price deflation. Instead, it was the fact that too many industries only had the capacity to produce things which weren't in demand anymore, meaning capital goods including houses and durable consumer goods. In other words, the primary cause was the malinvestments predicted by Austrian theory in more capital intensive industries, which given the loss of purchasing power for workers and owners there spread even to non-durable consumer goods and services.

Hanke finishes by noting how the unpredictable behavior of policy makers during the New Deal slowed the recovery and the similarities with that and the erratic and unpredictable behavior of Hank Paulson with regard to how the bailout money should be used. A good point, although it must be emphasized that predictable bad policies wouldn't be good either....

The other column is from Daniel Gross in Newsweek, which argued that we need not fear another Depression (Gross BTW repeats Hanke's error of looking at national income in nominal and not real terms). Again, I agree with that in the sense that I don't think it is likely that the slump will be fully as deep as the one in 1929-33. But let's just say that Gross' arguments aren't exactly strengthening my conviction of that. They are in fact weakening them.

The reason why Gross argues that this slump won't be as bad as that in the 1930s is because in the 1930s the government allegedly believed in laissez faire, while now they believe in the welfare state and bailouts of banks. As anyone who has read the Rothbard book knows, the assertion that the Hoover administration believed in laissez faire is simply false. The quote from Treasury secretary Andrew Mellon completely overlooks the fact that Herbert Hoover (the man in charge) ignored his advice and despite the disastrous results was always eager to emphasize just how good it was that he contrary to Mellon's advice pursued massive government intervention in the economy.

Now, to be sure, the bank bailouts will likely limit the degree of monetary deflation, which in the short-term can limit how deep the slump will be. But this will instead likely mean that the crisis will be even more prolonged, just like for Japan during the 1990s. While the short-term slump for that reason will likely be less severe than in 1929-33, it means that the recovery will be much weaker and short-lived, similarly to what happened in the Japanese case.

Monday, November 24, 2008

Rewinding The Tape On Fannie & Freddie

While the most important cause of the housing bubble was Alan Greenspan's low interest rate policy, certainly the active political promotion of credit financed home ownership in general and minority home ownership in particular played a role too. This press release from the White House is not remembered today, because both Republicans and Democrats for different reasons wants to forget about it (Republicans don't want to remember that it was their president that pushed for this, while Democrats don't want to remember the role of their beloved institutions Fannie Mae and Freddie Mac was behind it), but for those of us who aren't either partisan Republicans or Democrats, this information is very relevant today. An excerpt (Do read the rest as Bush lists a number of other government subsidies to promote home purchases):

"And let me talk about some of the progress which we have made to date, as an example for others to follow. First of all, government sponsored corporations that help create our mortgage system -- I introduced two of the leaders here today -- they call those people Fannie May and Freddie Mac, as well as the federal home loan banks, will increase their commitment to minority markets by more than $440 billion. (Applause.) I want to thank Leland and Franklin for that commitment. It's a commitment that conforms to their charters, as well, and also conforms to their hearts.

This means they will purchase more loans made by banks after Americans, Hispanics and other minorities, which will encourage homeownership. Freddie Mac will launch 25 initiatives to eliminate homeownership barriers. Under one of these, consumers with poor credit will be able to get a mortgage with an interest rate that automatically goes down after a period of consistent payments. (Applause.)

Fannie Mae will establish 100 partnerships with faith-based organizations that will provide home buyer education and help increase homeownership for their congregations. I love the partnership. (Applause.)"

Gordon Brown's Keynesian Experiment

That is true, sort of, in the sense that it is becoming increasingly apparent that more of the interest rate manipulations that got us into this crisis won't get us out of it. But the fact that monetary Keynesianism is increasingly discredited does not mean that fiscal Keynesianism is somehow vindicated.

It is one thing to announce tax cuts when you start of with a significant budget surplus, like in Sweden. It is very different to do it when you started of with a budget deficit of 3-4% of GDP at the peak of the cyclical boom, like in the U.K.

The most important measure of the package will be a reduction in the Value Added Tax from 17.5% to 15%. In addition, to that there will be some minor targeted tax cuts and increased public works and education spending. At the same time, they say they will plan to raise the top income tax rate from 40% to 45%, something which will bring little if any revenues while eroding the UK's competitiveness, although that will not be implemented until after the next election

Citigroup Bailout Means Large Subsidy To Citigroup

As most of you have probably already heard, Citigroup became the latest financial institution to bebailed out by the U.S. government. The bailout comes in the form of a $20 billion capital injection combined with a guarantee that the U.S. government will cover up to $249.3 billion in losses. Formally, the latter is structured as Citigroup taking the first $29 billion in losses from a $306 billion portfolio, with the U.S. government taking 90% of the rest.

In return, the U.S. government gets preferred shares of $20 billion yielding 8%, as well as a warrant to buy Citigroup shares during the next 10 years at a strike price of $10.61 billion.

The capital injection part of this seems pretty good for the government as they will get significant compensation. The loan guarantee however could mean quite significant losses, despite the fact that Citigroup will take the first $29 billion. Potentially, the losses could be as high as $249.3 billion. But that requires that all of the assets in that portfolio become worthless, so that is unlikely despite the fact that we're talking about very troubled assets. Most likely, losses will exceed $29 billion, so the government is going to have to take some losses, but probably not anywhere near $249.3 billion. Just how much is impossible to say, but it seems safe to say that this bailout nevertheless represent a significant subsidy to Citigroup.

Friday, November 21, 2008

Greg Mankiw On Real Bond Yields

A reader asked me to comment on this post from Greg Mankiw, which was based on a post from Paul Krugman where the below chart appeared.Apparently Krugman has calculated this by taking the nominal yields of AAA and BAA-rated corporate bonds and from that subtracting the differential between regular and inflation-protected 20-year government bonds. This increase in yields is to only a small extent the result of an increase in nominal yields with regards to AAA-rated bonds, while being to a larger extent the result of rising yields with regard to the BAA-rated bonds. The fact that corporate bond yields in general and BAA-rated ones in particular are up even as government bond yields are down clearly reflect an increase in risk premiums.

The increase is however also the result of a decline in the differential in between regular and inflation-protected bonds. For AAA-rated bonds, the decline in the differential between regular and inflation-protected bonds are more important than the increase in the nominal yield, while for BAA-rated bonds, the increase in nominal yields are more important.

Mankiw therefore proposes an inflation target as a remedy to this. With an inflation target, the differential in yield between regular and inflation-protected bonds will go up and so supposedly push down the real corporate bond yields.

But there are several problems with this. First of all, it is not even certain that the increase in yield differential between regular and inflation-protected bonds even reflects lower inflationary expectations. It probably does to some extent, but it also likely reflect a higher liquidity premium for the less liquid inflation-protected series. Secondly, inflation targets will have no effect on the increase in risk premiums which explain much of the increase. Thirdly, is there really anyone who doubts that the Fed is doing everything they can to inflate? The Fed has historically created a lot more inflation than other advanced country central banks without an inflation target and given the dramatic increase in the size of the Fed balance sheet, there can be little doubt that they are trying to reignite inflation. One can debate whether or not they will succeed, but as it is clear that they are trying, an inflation target wouldn't make any difference. And finally, since nominal yields are significantly above zero, an increase in inflationary expectations wouldn't push down real yields, it would only increase nominal yields.

Depression Update

-Initial jobless benefit claims reaches the highest level since 1992, with the 4-week average reaching the highest level since 1983, and the level of continuing jobless benefit claims reaching the highest level since 1982.

-The Swiss National Bank meanwhile seems to be in full panic as it reduced its target rate by a full percentage point, leaving it at 1%. Apparently, the Swiss National Bank believes it is more important to provide short-term stimulus than safe-guarding Switzerland's hard money status, something which is bearish for the Swiss franc.

-The U.K. fiscal situation continues to deteriorate. In October, net borrowings reached £1.4 billion, up from -£1.8 billion (i.e. debt was paid back by £1.8 billion) last year. For the first 7 months of the fiscal year, net borrowing rose from £20.1 billion to £37 billion. The U.K. now looks likely to have the by far biggest fiscal deficit of any major industrialized country except the U.S.

Misesians vs. Hayekians

Pehr asked me in the Q&A section about books on Austrian economics in Swedish to which I suggested Johan Hakelius' book "Den Österrikiska skolan" and to which Per-Olof Samuelsson also added the translated version of Alexander Shand's "The capitalist alternative". However, we warned him that these books focus on the Hayekian version of Austrian economics rather than the proper Misesian version (although that is discussed too). Pehr then came with the follow-up question of what the difference is between the Hayekian and Misesian version of Austrian economics.

That is an interesting question. For a more in-depth analysis I recommend Murray Rothbard's essay "The Present State of Austrian economics" where he analyses the difference between the Misesian version (which Rothbard belonged to) and the Hayekian version. Before I describe the difference between Mises and Hayek I should point out that there were actually "two" Hayek's, just like there were two versions of Hayek's cousin Ludwig Wittgenstein. Early in his career, Hayek was a Misesian and argued for the Austrian business cycle theory during the 1920s and 1930s. It was on the basis of this that Hayek received the Nobel price in economics in 1974. But then after World War II, he lost interest in business cycle theory and instead started to argue for the ideas described below.

In short, the Misesian version is based on what Ludwig von Mises called praxeology, which means the logic of action. Praxeology is based on a number of axioms, the most important of whom are the action axiom: the human beings act on purpose using means to achieve ends. Bases on this and a number of related axioms and laws of reality, you can then deduce a number of implications. Among the more immediate ones are that people will always choose the action they believe ex ante (before the action) will produce the best results, otherwise they wouldn't have acted that way. A second implication is that since the future is uncertain, people can't be certain that the action they perform will turn out to be the best. This uncertainty also implies that people will have to make forecasts about the future when deciding on which means to use in order to achieve the ends they want. But as people can only choose one specific form of action, every action is associated with a opportunity cost in the form of the actions they chose away.

Misesian praxeology then continues to deduce new logical implications in the above manner and apply them to more specific situations with certain specific conditions, such as the existence of money controlled by a central bank, advanced division of labor and a heterogeneous capital structure, and from that Misesians can derive advanced theories such as the Austrian business cycle theory. This approach, which is known as the axiomatic-deductive approach, is similar to the one in Mathematics and formal logic and is really no less certain than it. While Misesians can be certain of the economic laws implied by praxeological reasoning, they can't be certain of how applicable certain theories will be, but then again this is no different from how you can't be certain of how applicable mathematical conclusions like 103+201 are or for that matter how applicable physical laws and conclusions like how often airplanes will actually fly.

Misesian praxeology is thus based on logical analysis of how people try their best to use ends to achieve means and what that will mean given specific conditions.

Hayekians by contrast are not really interested in this kind of approach. For them reason is not an ally for acting man, it is a dangerous illusion and an enemy. The point of the Hayekian analysis is that acting individuals really can't alone come to any correct conclusions. Instead, truths and rules gradually evolve in a collective process governed by the anonymous spontaneous social forces, and while no one can really come up with anything individually, they can still learn somehow from the spontaneous social evolution, an evolution which is similar to the unplanned evolution we see in nature.

The Hayekian argument against socialism and government intervention consists in that socialism is based on the illusion that reasoning by any individuals (in this case politicians and other government officials) can be used to improve conditions. What Hayekians fail to see is that this argument will apply not only to government decisions but also to decisions made in any organization, including private companies. Indeed, it could even be made against any decision-making by individuals that doesn't involve simply mindlessly following what the group somehow comes up with collectively. By contrast, the Misesian case against government intervention consists in using reason in the form of praxeological reasoning to demonstrate the negative effects of such interventions.

In short, the difference between Misesians and Hayekians is a radically different view of reason and logic. To Misesians, people may be fallible, but they can and should still use reason to analyze the world around them and use these conclusions to improve the odds that the course of action they choose will turn out to be the best. To Hayekians, by contrast, belief in reason is a "fatal conceit" as Hayek puts it and the basis of socialism, while mindlessly following rules and ideas spontaneously evolved by the group is somehow the basis of a free society.

Japanese Trade Surplus Wiped Out

Despite the relief provided by falling oil prices (although the full effect of that has yet to be seen), Japan saw its trade surplus disappear in October as exports fell 7.7% compared to a year earlier while imports rose 7.4%. The spin by the Bloomberg journalist is that this reflects a weaker global economy, but as Japan is in a recession too, so imports should fall as much as exports if that had been the only factor.

Instead, this likely reflects the rapid appreciation of the yen. And as the full effects of that too has yet to be felt, Japan could continue to post trade deficits. This suggests that from a goods market point of view, the yen is no longer undervalued. Still, it will likely remain strong as long as the financial turmoil continues.

Wednesday, November 19, 2008

S&P 500 Back To February 1997 Levels

U.S. stock markets again fell dramatically today, with theS&P 500 falling 6.1% to 807. To see just how bad that is, we need to go back and see when the S&P 500 first reached/surpassed that level. That indicates just how long time anyone adopting a "buy and hold" strategy would lose

It could be argued that stock holders have received dividends during that time, but since holding stocks incurs the opportunity cost of interest yielding investments and since interest rates at comparable risk levels have almost always been higher, simply looking at price movements will if anything underestimate just how bad things are.

If we now go back we can see that the first time the S&P 500 reached at least 807 was February 14, 1997. Thus, for nearly 12 years, holding stocks would have been a losing strategy. Given that stocks because of their higher risk level should give a much higher return, this gives you a good hint of just how bad things are.

Tuesday, November 18, 2008

Q&A

The popularity of this blog has grown tremendously recently. I can still remember when I was excited about this blog getting 100 visits per day. In recent weeks, this number has grown to more than 1,000 per day. This is very good of course, although I still think that number is too low, considering the 50,000 to 100,000 numbers that Calculated Risk, Barry Ritholtz and Mike Shedlock have. I will therefore try to boost my visitor numbers further, something which readers can help with by spreading the word whenever you see any post you find particularly interesting or tip about this blog in general.

One side-effect of this growing popularity is that I am getting an increased number of e-mails asking me economics questions. I answer most of them, but they're becoming so many that I have difficulty finding time to answer all of them while having time for the blog and other projects that I'm involved with.

For this reason, I will introduce a new feature on this blog called Q&A, inspired by a similar feature on the blog of Swedish objectivist philosopher Carl Svanberg. In the comment field of the Q&A post you can post whatever questions you have about issues related to economics. Related to economics doesn't just mean questions about economic theory or how the economy works, but also related issues like economic policy, the epistemology and methodology of economics, economic history, financial market developments and so on. Questions that I consider completely irrelevant or otherwise inappropriate will however not be posted or answered.

The advantage of this feature is that not only does it give readers a place that they can turn too when they're uncertain about something, but they can also see in the comment thread whether I have already answered it or not, which in time will make it a reference point and almost an encyclopedia. In some cases I will simply answer by referring to an older post or article where the answer can be found. In some cases I will answer directly in the comment thread, in other cases when I consider it to be of particular general interest I will answer in a new post on the blog while in the comment thread linking to that new post.

I will therefore stop answering general economic questions via e-mail and instead refer those who continue to contact me to this post. Some of the questions I get via e-mail come from Swedes who -knowing that I am a Swede too- ask them in Swedish. I would prefer if even my Swedish readers ask questions in English (as most readers can’t understand Swedish), although I will at least sometimes approve (and translate for non-Swedish readers) questions in Swedish if you find it too difficult to formulate them in English. Since I don't understand other languages I will however not approve any questions in other languages than Swedish or English. This post will soon disappear from front page of the post section of the blog as new posts appear, but it will be a permanent feature of the side bar, that you can access whenever you have a new question. As an introduction I will answer two questions that have come via e-mail and in a comment thread on another blog and answer them in the comment section. To access that if you're on the main page click on either comments or the permanent link of this post.

The first question comes from blogger Wille Faler who wants to know more about Austrian economics and wonders which books I recommend. This is a question which I have received a lot of times from many other people, so it is clearly a good place to start.

The other question is not just one question, but several. The mail was written in Swedish by a student at the Stockholm school of Economics, but I'll present a translated version of them here:

1) Have I understood it correctly that the quantity theory in its modern version is incorrect? Is not velocity irrelevant for long-term general price increases?

2)I know that an (artificially) lowered central bank funds rate creates an increased money supply through a credit expansion, but I've also heard that an increased money supply lowers interest rates, which interest rates? What comes first, low interest rates or higher money supply? Why was inflation so high in Sweden in the 1980s when the central bank funds rate was also very high?

3)I know that an central bank is supposed to "control" inflation using the funds rate but that this is extremely difficult? In what other way do they directly control money supply? Does the central bank buy government bonds for money that don't exist and why do they do it and what happens when the bond is "paid back"? Who really controls money supply, the government or the central bank or both? I have read a bit Hazlitt and he makes it appear a little like the government creates money at will.

4) What does it mean when the central bank pumps in liquidity? Do they buy government bonds for money that doesn’t exist or do they give new loans to the banks?

5) Do all Swedish banks have the same reserve requirements? Where can you find information about that?

Surprise (Not)-Analyst Estimates Extremely Over-Optimistic

Back in early May, when I argued that the sucker's rally at that time in the stock market would end, I argued that the earnings forecast of so-called professional analysts were widely over-optimistic. Although I didn't in the post mention the estimates for the third quarter (I only mentioned the estimate for the fourth quarter), the Bloomberg article I linked to mentioned that analysts at the time forecasted an increase in profits of 12.1% for the companies in the S&P 500 in Q3 2008 compared to Q3 2007.

The 51.1% increase for the fourth quarter forecasted in May by analysts will almost certainly be even more incorrect. The change number for Q4 2008 will be greatly boosted by the fact that Q4 2007 was depressed by large write-downs. But I suspect that not even that base effect will prevent profit growth from being negative anyway. Considering the fact that house prices are falling at an ever faster rate, losses for financial companies will continue to be great. Meanwhile, the deep slump and the strong dollar is causing profits for non-financial companies to fall too. Also, the story about final earnings for Q3 2008 that I linked to mention that the one bright spot was higher profits for energy (i.e. oil) companies. But with the dramatic plunge in the price of oil, oil company profits will likely not only stop growing, but start falling.

The Case For GM Bankruptcy

Robert Tracinski has made an analysis very similar to the one I did of why the Democrats are pushing so hard for a Detroit bailout. Not so much to save GM, but rather to save the UAW and to seize control over operations and use this to make Detroit environmentalist. He further suggests that if the government takes control, GM should be renamed Trabant, after the extremely low quality East German car. Considering how low quality these green cars mandated by Obama and Pelosi are likely to be, Trabant will be a very appropriate name.

Meanwhile, Martin Feldstein argues the case for why chapter 11 bankruptcy is the solution to GM's problems because it will enable them to do away with the excessive wage and benefit levels in current union contracts. He further adds that any bailout should be coupled with demands for radical reductions in labor costs. But since one of the major points for the Democrats is to avoid that, they will be very reluctant to agree to that. They will likely only agree to that if they fail to lure over enough Republican votes to gain a filibuster proof majority in the Senate before GM goes bankrupt. If GM were able to avoid that until January when the Democratic majority till increase from 51-49 to at least 57-43 and maybe even as much as 60-40 (but probably somewhere in between) then that will be easy. But it will likely be a lot more difficult before that.

Monday, November 17, 2008

Can Media Lies Prevent An Economic Downturn?

Until very recently, the official view of the pro-Republican supply-side camp was that while there may be some problems in the housing sector, the overall economy was doing great. The talk of a recession was, to use the words of former McCain economic advisor Phil Gramm, merely reflecting a "mental recession". The fact that most Americans said they experienced economic hardship merely reflected how America had become "a nation of whiners". Others came up with an interpretation somewhat less dismissive of regular people. While the economy was really doing great, the fact that many people thought otherwise simply reflected how it was being slandered by the liberal media. If only the media had said that everything was going great, this view implicitly argued, then everyone would have thought the economy was going great and if they had simply argued that, then there wouldn't have been any problems.

In reality, the economy was not doing great, and the media was hardly slandering it. It was if anything depicting it in a too positive way by consistently underestimating or failing to recognize the problems. But more important, while the media depiction of the economy is not unimportant, it can't prevent problems from happening simply by lying and pretending the underlying causes of the inevitable problems don't exist.

This theory is now being tested in Russia. The Russian economy has been hit hard by the dramatic decline in the price of oil, its by far most important exports. The rouble has therefore fallen significantly and the stock market is down 75%. Yet as the universally state-controlled medias have banned the use of words like "crisis" and "decline" with regard to the Russian economy, it continues to say that the Russian economy remains strong-and no dissenting opinion is allowed. That alleged strength is of course universally credited to Vladimir Putin's leadership.

We will now see in Russia whether or not the media can really prevent an economic downturn simply by not reporting bad news and pretending that everything is going great. Since first of all many Russians can access foreign news sources and since secondly and far more importantly, economic downturns are not caused by psychology, I don't think it will succeed.

Solving The "Problem" Of Deflation

Evans-Pritchard argues that deflation has the effect of causing people to withhold shopping because they wait for prices to go down and that it increases the burden of debt. It is true that all other things being equal price deflation will increase people's willingness to postpone purchases, but that is no different from the effects of higher nominal interest rates, and to the extent nominal interest rates fall with inflation it will have no effect. And seeing how people buy for example computers and mobile phones even though they have fallen in price for decades (especially in quality adjusted terms), there is no reason to believe the effect will be that large. And a limited degree of postponement of purchases really isn't that bad as it increases the pool of savings and the real money supply, and as people will eventually buy those things (as Keynes put it, in the long run we're all dead so eventually they're gonna have to buy them).

As for increasing the burden of debt, that is not really a problem relating to lower price but to lower income. In fact, given a certain level of nominal income, lower prices will increase the ability to pay back debts as they can use the money saved on lower prices.

It should finally be noted that if the government truly believed that deflation was a big problem, it is in fact easily solved. And by that I am not referring to the various schemes that the Fed has put in place. Nor even to Bernanke's infamous helicopter scheme. There is actually no reason to bother sending out a bunch of helicopters to distribute the money when there's an easier and far more effective way of solving this problem: legalize counterfeiting!

Pass a law saying that as long as the government considers deflation to be a problem, anyone who makes new notes/bills that are fairly well made will get away with it and these bills will then be considered legal tender and allowed to be part of the money supply. This should first of all create a lot of jobs in the printing press manufacturing industry and is a full-proof way of fighting deflation as people would soon have loads of money, something which would definitely cause prices to go up, which in turn would make people less willing to postpone purchases and dramatically reduce people's debt burden. Deflation problem solved!

But, wouldn't this create big redistributive effects as some will not be able to afford to buy printing presses and other necessary input* and perhaps make the people who print the most so rich that they might not bother do honest work anymore? Yes, indeed, it would. But the point here is that this scheme really differs nothing from the regular process of inflation, except in the sense that we here have regular counterfeiters that benefits instead of the government and fractional reserve commercial banks, and that different people can earn their living through the redistributive effects of inflation instead of productive works. So in other words, no argument (except perhaps the opinion that they like better the people who now benefits from inflation) can be made against this scheme that is not also an argument against inflation in general.

*=Another more egalitarian and even more radical version of this scheme would be to allow people who can't afford to buy printing presses and other necessary input to buy it on credit and pay back using the money they later print. But since that would clearly create hyperinflation, it is not as similar to the existing money creation process.

UPDATE: See also Bloomberg columnist Michael Lewis' patriotic offer to take $5 billion from the TARP in return for a pledge to quickly spend all that in cooperation with his wife and family and relatives, thereby quickly putting the money in circulation and thus boosting the economy!

Sunday, November 16, 2008

Why Democrats Want Detroit Bailout

Advocates of a Detroit bailout often try to have you believe that if GM and the other Detroit auto makers went bankrupt, all of their operations would cease. But that would probably not be the case. Shareholders would lose all of their money (which is actually a good deal for them since GM has negative equity) and creditors would lose some of their money and they're gonna have to close more plants. But they would still be able to run some operations, just like many airlines that have gone bankrupt. If they through bankruptcy laws were able to be freed of some of their debts and more importantly, the union deals that means that the hourly cost of their workers are $73 per hour versus $48 for workers at Toyota plants in America, and if they reduced their capacity, then operations could be made profitable (at least once the current slump is over).

So why is it then so important for Obama and the Democratic congressional leaders to prevent this from happening? Charles Krauthammer gives a pretty good description of this in his latest column (The columns contains some nonsense about Republicans being too minimalist, but never mind that). First of all, they want to prevent or at least greatly limit the necessary reductions in wages and various benefits for Detroit auto workers that the United Auto Workers union has imposed. As unions are important donors to the Democrats, Democrats do as they wish.

Secondly, the bailout will almost certainly be linked to some form of demands for a green revolution in Detroit. As Krauthammer puts it:

"Once the government owns Detroit, it can remake it. The euphemism here is “retool” Detroit to make cars for the coming green economy.

Liberals have always wanted the auto companies to produce the kind of cars they insist everyone should drive: small, light, green and cute. Now they will have the power to do it.

In World War II, government had the auto companies turning out tanks. Now they would be made to turn out hybrids. The difference is that, in the middle of a world war, tanks have a buyer. Will hybrids? One of the reasons Detroit is in such difficulty is that consumers have been resisting the smaller, less powerful, less safe cars forced on the industry by fuel-efficiency mandates. Now Detroit would be forced to make even more of them.

If you think we have economic troubles today, consider the effects of nationalizing an industry of this size, but now run by bureaucrats issuing production quotas to fit five-year plans to meet politically mandated fuel-efficiency standards — to lift us to the sunny uplands of the coming green utopia."

Thus, while a bailout will cost taxpayers a lot of money and delay necessary restructuring and adjustments, it will please two key Democratic constituencies: unions and environmentalists.

Saturday, November 15, 2008

Disaggregating Consumer Spending Further

Contrary to the view of many people (mostly Keynesians) that consumer spending is what drives the economy, consumer spending as a share of the overall economy tends to move in a counter-cyclical way, which is to say it falls in relative terms during booms and rises during busts. I recently discussed how cars and other durable consumer goods are a exception to this rule as they tend to move in a pro-cyclical way, which is to say they rise during booms and fall during busts. But as I pointed out, this is only because they are in important aspects similar to investment goods and as overall consumer spending still moves in a counter-cyclical way in relative terms, this only implies that non-durable consumer goods and consumer services are even more counter-cyclical in relative terms.

Even non-durable consumer goods and consumer services however tend to see its growth rate rise in absolute terms during booms and fall during busts. This is because the bust in investment goods and durable consumer goods reduces overall effective production capacity so much that it overshadows the relative boom of non-durable consumer goods and consumer services. However, there are in fact some consumer goods that are counter-cyclical not just in relative, but in absolute terms as well. This include very cheap forms of food, such as noodles, baked beans and spam (not the infamous form of e-mail, but the food), which rises in demand during economic slumps, as the number of people who feel they cannot afford more expensive forms of food.

As Greg Mankiw points out, such goods are called inferior goods, which is not meant as a perjorative terms but as a way of describing its income elasticity

And so, we can divide up consumer spending in three categories:-Durable goods which are pro-cyclical in both relative and absolute terms.-Most non-durable consumer goods and consumer services which are counter-cyclical in relative terms but pro-cyclical in absolute terms.-Inferior consumer goods, which are counter-cyclical in both relative and absolute terms.

Time To Buy Stocks?

Via Greg Mankiw (who in turn got it from James Hamilton)I see this chart that illustrate that stocks are no longer overvalued from a historical fundamental perspective (something which I pointed out already last month).James Hamilton says that this implies that it is now time to buy stocks. I disagree. While we may see some form of short-term rally soon, that will likely not last. Because as the chart illustrates, during severe economic slumps like the 1930s and the late 1970s and early 1980s, stocks were much cheaper than they are now. Given the fact that I believe the current slump will be somewhere in between the 1930s and the early 1980s in severity, that means that stocks will have to fall a lot more than that before they hit bottom. Once they come closer to the lows of the early 1980s, buying might be a good idea, but not now.

Moreover, once the stock markets turn around, the U.S. stock market is not the place where you want to be. Stocks in Sweden and other European countries are much cheaper than U.S. stocks and will therefore rise a lot more once things starts to turn around.

Friday, November 14, 2008

How Growth Is Expressed In Different Countries

I try to be clear and avoid expressing myself in ways that confuses people. But sometimes that still happens as I assume that people are aware of all of the confusing aspects in which economics is discussed, which is not always the case. In my recent post about U.S. retail sales I wrote that I expected GDP to fall by more than 4% during the fourth quarter. That's bad, but it's not as bad as one reader thought it was, who believed that this meant that fourth quarter GDP would be 4% lower than third quarter GDP.

There are basically three ways in which quarterly growth can be expressed.

The first is the American way. Here growth is expressed in change from the previous quarter in annualized terms. Annualized terms means the 4 quarter change that would happen if the quarterly change was sustained for 3 more quarters.

The second is the European way. Here growth is expressed in quarterly change in absolute, non-annualized terms.

The third is the Chinese way. Here growth is expressed in change compared to the same quarter the previous year.

I call it the American, European and Chinese way as they are the most important countries/regions using the different ways of expressing growth, but many other countries choose to use these 3 different ways of expressing growth.

For example, let's say a country sees its GDP rise by 1% compared to the previous quarter in absolute terms and 3% compared to the same quarter last year. Using the American way of expressing growth, growth would be 4%, using the European way it would be 1% and using the Chinese way it would be 3%. Because the same data can be expressed in three different ways, it can be confusing. I will try to at least sometimes point out this briefly in future posts discussing growth in different countries, but in case I forget remember that I am using the local way of expressing growth (because I have readers from all over the world there is no common standard for them) and remember the difference in how numbers are expressed when comparing for example European and American numbers.

Bush Professes Belief In Free Markets

"Lame duck" president George W. Bush now says that he believes strongly in free markets:

"History has shown that the greater threat to economic prosperity is not too little government involvement in the market, but too much. Our aim should not be more government, it should be smarter government..... The answer is not to try to reinvent that system. It is to fix the problems we face, make the reforms we need, and move forward with the free market system"

Oh? Too bad you didn't apply that alleged belief in free markets and opposition to government involvement to the education and prescription drug sectors, instead of expanding the governments' and reducing the market's role through the No Child Left Behind act and Medicare prescription drug benefit plan. And too bad you didn't apply that to the monetary sector by abolishing or at least reining in the Fed, instead of allowing Greenspan to create a housing bubble and now letting Bernanke use the aftermath of the bubble to expand the Fed's balance sheet.

Well, at least it sounds good, you might say. But to let Bush which is associated with the economic slump to be associated with a free market philosophy is in fact as bad for the free market philosophy's reputation as letting Greenspan be associated with it.

Retail Sales Collapse Too

U.S. retail sales fell 2.8% in October compared to September, the biggest monthly decline ever during the 16 years this retail sales statistics have been compiled. Sales fell the most for cars and gasoline, but dropped for most other things as well.

The drop in consumer spending is ultimately inevitable and sound as Americans needs to save more. But to the extent it is being replaced by government purchases, this shift is not so sound. And this news certainly confirms my view that the fourth quarter will see a drop in GDP of more than 4%.

Thursday, November 13, 2008

Dramatic Decline In U.S. Exports

Today's trade report confirmed what I had expected: namely that the overall U.S. trade deficit would decline because of the dramatic decline in the price of oil, but that the stronger dollar and weaker foreign economies would cause U.S. exports to collapse and cause a significant increase in the non-oil deficit (as the effect of these two factors are clearly negative on exports and ambigious on imports).

In the coming reports, we should see a continued dramatic increase in the non-oil deficit combined with a similar dramatic decline in the petroleum deficit. What this implies is that in the headline volume statistics, foreign trade will be a significant drag on the economy as these statistics ignore the terms of trade factor. Properly measured, which is to say terms of trade adjusted, the effect will be moore neutral. But as foreign trade is usually expected to be a positive during downturns, the fact that it isn't now is still a drag.

Wednesday, November 12, 2008

Pound Falls To New Lows (Again)

The U.K. pound fell to yet another low today, reaching a new all time low against the euro, at less than €1.20/£ (which in inverted terms means that the pound cost a record high €0.84). It also reached a 6 year low against the U.S. dollar and a 13 year low against the yen.

The supposed reason for the decline was that the Bank of England forecasted weaker growth and inflation, which of course means increased likelihood that they will cut interest rates further. But given the fact that they had already signaled that they would emulate Ben Bernanke's aggressive strategy and ignore its inflation target, I find it strange that anyone would find it surprising that the Bank of England is planning more aggressive interest rate cuts.

Tuesday, November 11, 2008

Detroit Auto Workers Are Overpaid

While there are other factors behind the deep crisis of the Detroit auto industry, including the deep cyclical downturn and the until recently high gas prices, a key factor behind their problems is that workers are overpaid. As Mark Perry here shows, the total pay (including various benefits) for Detroit auto workers are more than 2.5 times higher than that for the average American worker ($73 per hour versus $28) and more than 1.5 times ($73 per hour versus $48) higher than the total pay of those that work in Toyota factories in America. High pay may not necessarily mean that you are overpaid, but given the chronic losses of Detroit auto companies, clearly Detroit auto workers are overpaid and it is obvious that the very high cost of labor is a factor behind Detroit's problems. While a bailout may save these companies temporarily, a sustainable survival clearly depends on reducing labor costs.

Monday, November 10, 2008

Krugman, FDR & Keynesian Policies

There is a debate over what kind of Democratic president Obama will be. Some hope (or fear in cases of leftist Democrats) that he will be a moderate like Bill Clinton and Jimmy Carter, while others including me fear (or hope) that he will be a radical that significantly expands government power, like Franklin Roosevelt or Lyndon Johnson.

Paul Krugman, who supported Hillary Clinton in the Democratic primaries, isn't entirely sure of whether Obama will be a moderate or a radical. But he clearly says that he thinks Obama should be radical like Roosevelt. Indeed, in his latest New York Times column and in several posts on his blog, he thinks that Obama should be even more radical than Roosevelt. In particular, he thinks that FDR was too cautious in allowing the budget deficit to expand until World War II.

Several points can be made about this: First of all, his measurement is the so-called "full employment" deficit. That means that the so-called automatic stabilizers (a cyclical downturn reduces tax revenue, while increasing spending on welfare and unemployment benefits without any active political decisions) that Keynesians actually usually celebrate as a big advantage of a welfare state are excluded. But since such alleged stabilizers wouldn't exist in a pure laissez-faire economy, they do in fact constitute a form of Keynesian intervention.

Secondly, as Alex Tabbarok points out, one reason why the increase in the deficit were limited was because first Herbert Hoover and then Franklin Roosevelt implemented significant tax increases (See Greg Mankiw's illustration of tax rates during Hoover & Roosevelt). The increase in government spending was enormous, but only some of that was financed through higher taxes rather than increased borrowing. If Krugman thinks that Hoover and Roosevelt did the right thing with regard to spending, but erred in financing some of it through tax increases, does that mean that he now favors keeping the Bush tax cuts in place?

It should be further noted with regard to this point that direct government spending is usually regarded by Keynesians as superior to tax cuts (especially tax cuts for people with high income) because there is a risk that they might save some of it. So, the Hoover-Roosevelt strategy of raising marginal tax rates and spending it directly could too be considered a form of Keynesian policy.

Finally, Krugman completely ignores (typically enough for a Keynesian) the long term effects of large deficits and high spending. If you study the economic data for Japan during the 1990s you can see that whenever they temporarily accelerated the increase in the deficit it did produce a short-lived upswing. But that upswing soon disappeared, and Japan's once awe-inspiring growth rates fell to the lowest of all industrial economies, as all of its savings were diverted into government bonds, as opposed to private investments. It is interesting to see that he criticizes Roosevelt for tightening fiscal policy in 1937, several years after GDP started growing again. What Krugman apparently advocates are not temporary deficits, but permanent deficits, something which will have a negative effect on growth because of the crowding out effect.

Krugman may have been a good trade economist, but he is not a good macro economist. Too bad he has stopped writing about trade and instead has focused on macroeconomics.

Sunday, November 09, 2008

Detroit Auto Industry Problems & Austrian Business Cycle Theory

Continuing on the subject of the problems of Detroit auto makers, it should perhaps be discussed where this fits into Austrian business cycle theory. As most of my readers presumably know, Austrian business cycle theory predicts that the downturn will primarily be in the investment goods sector. Yet business investments have in this downturn not been particularly weak so far. However, residential investments have plunged more than in any other previous slump, falling from a peak of 6.3% of GDP in the second half of 2005 and 4.4% in Q3 2007 to 3.3% in Q3 2008. As a result, the investment sector as a whole has suffered more than consumer spending.

Even so, the auto industry has also declined sharply. Can this be explained with Austrian theory? Perhaps not with the classic formulations of it, but it can be explained with it through an updated version that applies the logic inherent in the theory on other areas. The distinction between capital goods and consumer goods is in fact not as sharp as many people think. There are some goods which can clearly be classified as consumer goods, such as say fresh fruits which must be more or less immediately consumed, and others which are clearly capital goods such as industrial robots. But for other goods, it is not as obvious whether they should be classified as capital goods or consumer goods. If you for example build a new store, then this will enable consumption of the goods sold in it as soon as it is ready, yet it is considered a investment good. Similarly, houses are considered investment goods even though the purpose of them is to enable people to enjoy housing services. What about the products of GM and Ford, cars, then? They are considered consumer goods even though most of the value in them won't be consumed during the first month, quarter or even year after they're bought. Most cars last for decades, and so they are arguably to some extent capital goods. This is even more evident if you consider that cars are often used for job-related purposes.

And so since cars can be considered as a form of capital goods, the logic inherent in the Austrian business cycle theory that capital goods should be especially cyclical can be applied to the auto industry. As car buyers suffer interest costs (either direct interest costs if they borrow the money, or the opportunity cost if they buy it with their own money), an artificial lowering of interest rates should result in an artificial boom in the auto industry, which will then turn into a bust. And so, the problems of the Detroit auto makers are in fact very much consistent with what the Austrian business cycle theory would predict. Note that this doesn't just apply to cars, it applies to all durable consumer goods.If you look at the historical data, you can indeed see that durable consumer goods have in fact fallen as a percentage of GDP during recessions and risen during booms. For example between 1972 and 1975, durable consumer goods fell as a percentage of GDP from 8.9% to 8.1%. Between 1979 and 1982, durable consumer goods fell from 8.4% to 7.4%. Between 1989 and 1991 it fell from 8.6% to 7.6%. The 2001 recession saw a very modest decline from 8.8% in 1999 to just 8.7% in 2001, but in the current recession we have seen it decline from 7.8% in Q3 2007 to 7.1% in Q3 2008. A further decline in the fourth quarter seems almost certain.

So to summarize, despite the fact that cars are considered consumer goods, the problems of the car industry are very consistent with Austrian business cycle theory. Another conclusion that can be drawn is that the cyclical fluctuation in savings is even greater than the usual measures of national savings. Since consumers during booms buy durable goods which are consumed during recessions too, the fluctuation in consumption is even smaller than official statistics suggest. But since this has no implication for the value of production, a smaller cyclical fluctuation in consumption implies a greater cyclical fluctuation in savings.

How Lehman Collapse Elected Obama

After Tuesday's electoral defeat, something of a Republican civil war has erupted. Prominent conservative pundits like Rush Limbaugh and Ann Coulter who strongly opposed McCain during the Republican primaries, but temporarily stopped criticizing him before the election because they disliked Obama even more and because they liked Sarah Palin, have now again started to attack McCain and his associates and blamed the defeat on McCain being the Republican candidate. More moderate Republicans by contrast blame Palin for the defeat, and some McCain staffers have even started to launch an anonymous smear campaign against Palin by for example alleging that she didn't know that Africa is a continent and not a country. These allegations are clearly false (See here for more on this. See also this on some other false smears) but the fact that such a campaign has started does not bode well for the Republican party.

In reality, the cause of the Obama victory is neither McCain or Palin. The cause is instead the acute financial crisis that began in mid-September after the collapse of Lehman Brothers and the sharp economic slump this triggered. While the Republicans really weren't more responsible for this than the Democrats (Republican presidents Reagan and Bush Sr. and Jr. did nominate Alan Greenspan, but so did Democrat Bill Clinton) and Obama's solutions sure weren't any better than McCain's (quite to the contrary), but since normal people don't understand these things very well and instead instictively blame the incumbent party, McCain lost a lot of voters to Obama because of this. Remember, before the Lehman collapse, McCain actually held a lead in the polls, so it is likely that had the Lehman collapse occurred just two months later, Obama would have lost.

There's little doubt that Obama will agree to it. The question is whether Bush will veto it or not. Given the fact that GM might go bankrupt before January 20, 2009, that is an interesting question. Let's just say though that I wouldn't exactly count on a veto, given Bush's past failure to adhere to free market principles.

Saturday, November 08, 2008

ARI On Greenspan

Apparently, at least one reader misinterpreted, what I wrote on the Ayn Rand Institute's view of Alan Greenspan. I thought I was very clear in describing it as negative, similar to the view of the Ludwig von Mises Institute, but apparently at least one person misinterpreted it as being positive, similar to the view of the Cato Institute (or more correctly the authors of this Cato report, and most others active there. But in all fairness it should be acknowledged that there are some in the Cato Institute who view Greenspan in a more realistic, which is to say more negative, way).

To ensure that no one gets a misleading view of where the ARI stand, I will link to a article on Greenspan from the ARI, that a person related to ARI contacted and tipped me about. Whatever your opinion of the ARI on other issues and on other grounds, I recommend you to read it as it is quite good and should do away with any misunderstandings on where the ARI stands on this issue. It is interesting to see the positive reference to Ludwig von Mises BTW.

General Motors' Massive Negative Equity

Yesterday, I discussed the possibility of General Motors going bankrupt. But what few have noticed is that by some measures, General Motors should have been declared bankrupt for some time now. I mean, there have been several years since GM made a profit. Year after year have passed by with loss after loss reported. And moreover, until just a few months ago, GM was actually incredibly enough paying dividends.

The result of this is that GM now has negative equity-and we're not talking about small sums. As you can see here, on June 30, General Motors had assets to the value of $136 billion and liabilities of $193 billion, implying a negative equity of $57 billion!. And with the loss they reported for the third quarter, equity is presumably even more negative now. And given how dire the outlook is for car sales, can anything but increased losses be expected?

Ford's situation is BTW not quite as bad as General Motors', but they too have negative equity as assets stood at $265.3 billion and liabilities/debts at $267 billion. And as Ford continues to accumulate losses, their negative equity should get bigger and bigger.

GM and to a lesser extent Ford are broke and run operations which are simply economically unviable. They really should therefore go bankrupt and have their assets liquidated. But I doubt that the future President Obama will let that happen considering how many auto workers who would become unemployed in a time when unemployment is already rising fast and considering the support Obama has gotten from unions (Detroit auto workers are heavily unionized).

Friday, November 07, 2008

Economic Crisis Deepens

-Today's U.S. employment report was very bad. Although I had expected something more like 300,000 in net losses in payrolls, instead of the 240,000 now reported, it appears likely that subsequent revisions will put the final number above 300,000. After all, almost all releases for the last year or so have featured downward revisionsof previously reported job growth or upward revisions of previously reported job losses. And that certainly included this one that featured an unusually high total downward revision of the previous employment level (i.e. upward revision of net job losses) of 179,000. So, the reported level of payroll employment was in fact 419,000 lower than the level reported last month. Hours worked also fell significantly again. The only thing positive is that average hourly earnings increased, albeit only 0.2%. Given the decline in oil prices that should in fact translate into increased real hourly earnings.

The household survey basically confirmed the weak state of the job market that the payroll survey indicated with an increase in the unemployment rate from 6.1% to 6.5% and a job loss of 297,000. Given how fast the economy deteriorates, I think the unemployment rate will likely rise above 7% as early as January, and then rise to 9% or so by the end of 2009. Before the current downturn is over, a double digit (above 10%) unemployment rate is possible and even likely.

-Meanwhile, the U.S. auto industry appears to face a dimilar meltdown as the financial and construction industry. Both General Motors and Ford reported enormous losses and in the case of General Motors,they appear to face bankruptcy in the coming months unless the government bails them out.

That is something which will most likely happen, as it seems implausible that the "Joe six-packs" working in the Detroit auto industry would be denied a bailout at the same time that super-rich Wall Street bankers receive a bailout.

-But that will of course further increase the U.S. budget deficit. Given the deep economic slump, the "stimulus package" that Obama has said he will favor and the costly bailout of both Detroit and Wall Street, a trillion dollar deficit actually looks like a over optimistic at this point. The Congressional budget office today BTW reported that the October 2008 deficit will likely be $77 billion higher than the October 2007 deficit. Of that $18 billion can be attributed to the Wall Street bailout and $27 billion from calendar effects. But with the bailout being a permanent (for the rest of the budget year) factor it should not be excluded. The $27 billion in calendar effects should arguably be excluded but that still leaves us with a $50 billion underlying monthly deterioration. And as last year's deficit was $455 billion and as $50 billion deterioration in a month translates into $600 billion in a year and as the economy is likely to deteriorate further in coming months and as we are likely to see additional "stimulus packages" and bailouts, it should be obvious to anyone familiar with basic math that the annual deficit for 2009 will end up a lot higher than a trillion dollars.

As for low inflation, I guess that's true if you define low as lower than under Robert Mugabe or even Arthur Burns. But America's inflation rate under Greenspan was consistently higher than in almost all other major industrial countries and almost all Fed chairman’s before Arthur Burns. What about dampening the business cycle? That is definitely not true, because first of all certain structural factors unrelated to monetary policy have caused business cycle fluctuations to decline and secondly, as I've pointed out before, while Greenspan's radical 2001 rate cuts probably made the 2001 recession milder than it otherwise would have been, the result of this was pnly to postpone and to further aggravate these problems. The extremely deep downturn America is facing now is a direct result of these rate cuts and as this will be a really deep slump, a and so claiming that Greenspan has "dampened" the business cycle is a bizarro world assertion.

In the report, the Cato authors David Henderson and Jeffrey Hummel, note that by 2006, money supply growth had fallen sharply compared to 2001, regardless of whether your preferred measure of money supply is M1, M2 or MZM. That is true, but that certainly does not somehow prove that Greenspan's interest rate cuts wasn't responsible for the bubble. The housing bubble by all measures started in 2001. Before that, the level of house prices, construction activity and mortgage debt was reasonable by historical standards. But then during 2001, house prices and mortgage debt started to suddenly rise above 10%-during a recession when they usually decline. And unusually enough for a recession, residential investments increased. Normally residential investment is the most cyclical component of GDP, falling even more than business investments during slumps. But during the 2001 recession, it actually rose even as business investments slumped. This would clearly suggest that the surge in money supply helped kick start the housing boom. That money supply growth had fallen sharply by 2006 is also very consistent with the link to the housing bubble, since residential investments reached its peak during Q4 2005. Other indicators of the housing bubble such as housing prices and mortgage debt continued to increase a bit longer, but given the lags in monetary policy that is still consistent with the monetary explanation.

They then argues that the fact that many parts of broader money supply measures M2 and MZM lack reserve requirements somehow mean that the Fed can't control them . That is true in the sense that the Fed doesn’t decide on the exact money supply increases in their meetings. As I've explained before, money supply is a residual factor of the interest rate that the Fed sets and the various other factors that affect interest rates. Or more correctly, the other factors that would have affected interest rates if the Fed hadn't fixed it. Now that the Fed has fixed it, these other factors instead affect money supply. But, by fixing interest rates at a certain level the Fed is ultimately responsible for the increases in the money supply and it could have controlled it if it had targeted it instead of interest rates. Furthermore, during the latter part of the housing bubble, money supply increases arguably understated the Fed's role. The reason for that is that because the low interest rate set by the Fed caused a downward pressure on the U.S. dollar, foreign central banks that wished to avoid seeing their currencies appreciate relative to the dollar started to buy U.S. securities, and so helped keep down U.S. interest rates without any increase in the U.S. money supply.

Henderson & Hummel then asserts that the Fed does control the monetary base. But while it is true that the Fed could potentially control it -like it could with the overall money supply- the fact is that it doesn’t as long as it is interest rates that they target. The monetary base as they note consist of two components: currency in circulation (paper and metal cash) and bank reserves. They themselves immediately note that the quantity of currency in circulation is determined by domestic and foreign demand for it. And they further note that these days (or more correctly, until mid-September) currency in circulation constitutes more than 90% of the monetary base. But they appear to believe that bank reserves by contrast are, or were, directly determined by the Fed.

But that is simply not true, nor has it been true. And I find it astounding that they and many other professional economists don't seem to understand the dynamics of how the monetary base was determined. The dynamics of bank reserves have recently changed radically for reasons I explained here, but before this recent upheaval bank reserves were for years basically constantly unchanged at roughly $70 billion. Henderson & Hummel takes this as evidence that the Fed's interest rate moves mimicked fluctuations in the natural interest rate. Just how Greenspan and his associates could have been so remarkably skillful in predicting movements in the natural interest rate is not made clear, but I guess they figure that Greenspan was the great maestro and so was perfect.

But as I pointed out in a response to a article from Robert Murphy (who is usually a lot more insightful than Henderson & Hummel), bank reserves are not determined by the Fed, and this is especially true after the 1994 reforms they themselves mention that allows banks to "sweep" money from demand deposits (with reserve requirements) to savings deposits and money market funds (without reserve requirements). Instead, above the necessary minimum reserves required by the amount of money that they for various reasons must continue to classify as demand deposits, banks have complete discretion to determine how much reserves they want to hold. And before the upheaval that began in September this year, banks had every reason to minimize reserves to the legally required level. The reason was that they could always count on immediate liquidity infusions from the Fed in the case of a liquidity crisis. Meanwhile, as bank reserves yielded zero, they had strong incentives to recycle all cash infusions into the money markets or into loans. Meaning that the quantity of bank reserves was unaffected of how tight or loose monetary policy was, and so was useless as a indicator of that.

To summarize, the report demonstrate a complete lack of understanding of monetary economics dynamics. So here we have leading self-described libertarian think-tank who hires economists who don't understand the dynamics of monetary economics and who by their own admission in the report can't come up with any explanation of the current crisis to produce a report with the purpose of defending a government institution from the allegations that it rather than the free market is responsible for the crisis. Am I the only one who thinks that there is something wrong with this picture?

Now, to be sure, given how erratic the stock market has behaved in the last 2 months or so, this sell-off may be related to something else. But regardless of to what extent investors actually sold off because of the Obama victory, the real point is that they should have done so.

With Obama as president, not only will the economy slump even more than it otherwise would have done, but Obama will also slap U.S. multinational companies with extra taxes on the profits of their foreign subsidiaries. A kind of de facto tariff that only applies to U.S.-based companies, while their foreign based competitors This will lower the present value of future profits from these subsidiaries, which in turn implies that the fundamental value of U.S. stocks will decline. So, while we can't be sure that the investors who have sold stocks in the last 2 days have been aware of this, we can be sure that the price movement their actions generated mimicked the rational response to the Obama victory.

Bank Of England's Shock Cut

Following recent similar moves by the Fed and the Swedish Riksbank, the ECB and the Swiss National Bank both cut their official interest rates by 50 basis points. But compared to the surprising drastic 150 basis point cut by the Bank of England today, these cuts looked like hawkish moves in comparison.

The Bank of England now has lower interest rates (3% versus 3.25%) than the ECB for the first time ever during the 10 years that the ECB has existed. Considering that risk premiums on credit markets have declined and considering that inflation in the U.K. is more than 5%. The sharp decline in the price of oil probably means that inflation will fall even in the U.K., but considering how weak the pound is, inflation will probably not fall to the 2% target. The Bank of England is apparently so scared by the present U.K. downturn that it in effect has suspended its inflation target. Given that inflation targeting isn't a good idea that is not necessarily a bad thing. But suspending it in an asymmetric way (ignoring it when inflation overshoots, while adhering to it when it undershoots) implies a strong inflationary bias.

While everyone is now trapped in a Keynesian mindset that only the short term matter, we shouldn't forget that it was the previous inflationary bias that created these problems in the first place, and that doing it again will create more problems. That is why it is good to see that there seems to be some central bankers who remember this. ECB executive board member Lorenzo Bini Smaghi commented the call for even more drastic cuts (like Bank of England's) this way:

"The present crisis is partially due to interest rates that remained at low levels for too long. At that time, rates were lowered too much in order to stimulate growth. We need to avoid repeating the same mistakes."

Now We'll See If Lenin Was Right

The one silver lining that can be found in this misery is the one I mentioned after Congress passed the Wall Street bailout: namely, now the coming economic problems to a higher extent be associated with bad policies. Even had McCain won -or indeed even had Ron Paul won-, the American economy would have faced serious problems due to the damage created by Alan Greenspan. While the problems wouldn't have been fully as bad as they will be now, it still would have been bad. And so, to some these problems would to some have been associated with the lack of the kind of socialist policies that Obama stands for.

Now, with both Congress and the White House controlled by the Democrats, America will pursue consistently statist and so consistently destructive policies, policies that will now hopefully be associated with the coming economic problems.

This kind of reasoning was reportedly first adopted by Vladimir Lenin who argued to his fellow communists that "worse is better". By that he meant, that communists should welcome if things get worse for the common man under non-communist rule, since that will increase their willingness to turn to communism for alternative solutions. While presumably nearly all of my readers disagree with Lenin's communist policies, one can't deny that he was a smart and successful strategist (after all, he and his fellow Bolsheviks did win in Russia). But then again, there is little evidence that it was the "worst is better" strategy that worked for him.

Given the fact that things will now be worse, we can only hope that Lenin's "worse is better" strategy will work for the anti-statist political forces in this case. It wll be years at least before any definite conclusions can be drawn. I am however quite pessimistic about this considering how the failed statist policies of Franklin Roosevelt or Lyndon Johnson failed to strengthen any anti-statist backlash. And while the U.S. economy will certainly contract for the coming year or so, there might be a temporary cyclical upswing before 2012. Leftist economists will likely try to falsely credit that temporary cyclical upswing to Obama's policies.

Hopefully, I am too pessimistic about the outlook for Lenin's "worse is better" strategy now that we know that a turn for the worse will occur, but I doubt it. And the only thing we know for certain is that things will get worse in the near future because of Obama's victory.

Monday, November 03, 2008

About The U.S. Presidential Election

Tomorrow, as you all know, there will be a presidential (and congressional) election in the United States. Barack Obama looks most likely to win considering his consistent lead in the polls, but as polls aren't always completely reliable a victory for John McCain certainly can't be ruled out. What definitely can be ruled out however, is a win for any of the "third party" candidates: Bob Barr (Libertarian Party), Chuck Baldwin (Constitution Party), Ralph Nader(Independent, previously Green Party) and Cynthia McKinney (Green Party). For them it will be a success to reach just 1% of the vote.

I am not an American citizen and so I cannot vote in the election. But as many of my American readers have asked me what I think about Obama's and McCain's economic plans and since in the current globalized world economy, economic policy in the biggest economy, the United States, affects even those of us who aren't Americans, I will still provide an analysis of the economic plans of the candidates.

Even though none of the "third party" candidates have any chance of becoming president, I'll still briefly discuss them, as many Americans for understandable reasons cannot bring themselves to vote for either Obama or McCain. Nader and McKinney did oppose the Wall Street bailout on egalitarian grounds and they support reducing military spending. But being socialist environmentalists their economic plans can still simply be summarized as awful. Chuck Baldwin is good on monetary policy and advocates abolishing the Fed and of course also opposed the bailout. He also favors abolishing the income tax. He is however absolutely awful on trade policy, as this page on his campaign web site makes clear. Bob Barr seems to have the best policy overall, being similar to Baldwin except he doesn't advocate the kind of ultra-protectionist policies that Baldwin favor.

McCain's economic plan looks mostly good. He advocates significant corporate income- and capital gains tax rate cuts, as well as increase the deductibility of capital expenditure (which in effect amounts to a tax cut) and abolish the Alternative Minimum Tax. He wants a one year freeze on non-military, non-veterans spending and advocates various other spending cuts. Given that he has frequently criticized Bush and his fellow congressional Republicans for lack of spending restraint, it would seem that he has some credibility on this issue. However, it should be mentioned that the National Taxpayer's Union claims that he has also proposed various spending increases, and of course, if he starts a war somewhere (perhaps not likely, but certainly possible) then military spending will increase.

What also sounds good about McCain is that he advocates reduced trade barriers and allowing increased drilling for oil as well as allowing more clean coal and nuclear power, all of which will provide a much needed relief in the price of oil and energy. He also proposes lifting the tariffs on foreign ethanol. I do however dislike the widespread use of "tax credits" to benefit various "renewable" energy sources.

McCain's suggestion that the government should start directly take over mortgages from mortgage lenders is certainly a foolish idea and so a negative for him. But then again, that's what the U.S. government directly or through the Fed is actually already doing, so it wouldn't really represent a change for the worse.Obama's plan is far worse across the line. One thing that looks good is that capital gains taxes for new and small businesses will be eliminated. But even that might not be as good as it first looks since the restriction to new and small business seem to imply that they will be phased out with time and size of business, meaning that they could create negative incentives that prevent small businesses from growing and encourage existing businesses to be closed down.

Perverse or negative incentives are of course also a key problem with his highly touted "middle class tax cut for 95% of working families". As this tax cut comes in the form of a $1000 tax credit which is phased out with rising income, this tax cut will actually increase the marginal rate of taxation. And that is very bad for economic efficiency and growth. See more on this issue here. Another problem with this "tax cut" is that it goes to many people who don't pay any tax, making it a welfare scheme more than a tax cut.

And while he strangely doesn't mention it on his campaign web sites, he advocates significant increases in the top income tax rate as well as the taxation of capital gains and dividends, something which is also very bad.

He further argues for countless spending increases on health care, "renewable energy", job training, corporate subsidies and hand-outs to state and local governments and so on. The National Taxpayer's Union claims that these spending increases add up to $300 billion annually. While he has sometime promised to "end programmes that don't work", he has usually been vague about what that' supposed to mean. The few times he has mentioned anything specific, it has relied on the idea that cutting out private suppliers will save money, something which is not always but usually a fallacy, as Robert Murphy points out here. And while he has pledged to withdraw gradually from Iraq, those savings will go to other military spending projects. In short, we would see a massive expansion of spending under Obama, even if you disregard the welfare hand-out character of many of his "tax cuts".

On trade, he refrains from the kind of explicit protectionism that Chuck Baldwin pushes. But the protectionist message is very clear as he advocates forcing poorer countries to adopt "stricter labor and environmentalist standards". Also, he says he wants to end "tax breaks to companies that shift jobs overseas". In preparing this post, I tried to find out what that means. Has Congress passed a "Tax breaks for companies that shift jobs overseas Act"? No, of course not. I am still not completely sure as to what, if any, tax code this refers to, but I think he means the provisions in the U.S. corporate tax code that is designed to prevent double taxation of profits by foreign subsidiaries of U.S. multinational companies. This kind of practice exist almost everywhere as it otherwise would put a country's multinational companies at a great disadvantage, having to first pay corporate tax in the country it operates in, and then in the country where it is headquartered. This practice means first of all that foreign profits aren't taxed until it is repatriated to the country where the company is headquartered and secondly that a company can deduct taxes it has paid offshore so as to avoid double taxation. If that is what he means by "tax breaks that shift jobs overseas", then doing away with that would greatly damage American multinational corporations, and so also lower stock prices. This together with a proposed "tax credits" for companies that increase domestic operations relative to foreign might perhaps increase the willingness of American companies to move foreign production to America, but the main effect would be to simply damage the competitiveness of these companies as they are forced to choose production alternatives which are less competitive. And as they in effect amount to tariffs on products produced outside America by American companies, they will damage the global economy as a whole and the rest of the world.

Furthermore, on labor issues, Obama wants to pass various laws to raise minimum wages and strengthen unions, which will raise unemployment. On energy issues, he and Joe Biden opposes increased oil drilling, coal production and nuclear power and instead favor massive government subsidies into "renewable energy sources". He also endorses the extreme environmentalist goal of reducing carbon dioxide emissions by 80% by 2050 through the use of government controls.

In short, while McCain's plan is far from perfect, it is significantly better than Obama's.

Another thing that has to be taken into consideration is the fact that the president is after all not all powerful. The president's power is checked by that of the Congress. And congress is likely to see a significantly enlarged Democratic majority. What does that mean for the relative attractiveness of McCain versus Obama.

Well, that means that if McCain is elected, he will, being a Republican, find it very difficult to enact his policies. And that applies both for his good policies and his bad policies. Similarly, with McCain as president, most of the ideas of the Democratic congressional majority will be blocked. This means that if McCain is elected, we won't see much change in U.S. governmental policies.

If Obama is elected on the other hand, then we will indeed as Obama keeps saying, see change. The problem is that it won't be positive change, it will be negative change. With the U.S. in a deep cyclical downturn and with both the White House and Congress controlled by the Democrats, we are likely to see a massive expansion of government power. America will likely see a negative transformation in statist direction, perhaps similar in significance to the transformation we saw after Franklin D. Roosevelt was elected. The Obama policies of higher marginal tax rates across the board, higher government spending, increased regulation and protectionism will seriously damage a already weak U.S. economy, something which will of course also hurt the rest of the world economy.

The above mentioned facts are of course something which my American readers should take into account before voting.

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